Polarised EMU ahead of Greek elections

Greek bond dilemma points to postponement of full-scale QE

by David Marsh

Mon 5 Jan 2015

The spectre of a still more polarised and fragmented single currency bloc is haunting European policy-makers as a result of controversy over possible quantitative easing ahead of the Greek elections on 25 January.

The European Central Bank is considering forms of QE that would stop well short of full-scale across-the-board purchases of member countries' government bonds and would end up further dividing economic and monetary union between creditor and debtor states.

The calling of a snap Greek election rules out a decision on comprehensive QE, defined as purchases of sovereign bonds of all of EMU’s now-19 member states, at the European Central Bank's next monetary policy meeting on 22 January.

The ECB cannot be seen to be interfering in the Greek election by purchasing Greek bonds ahead of the poll, where the issue of Greece's continuing EMU membership will play a major role. Central banks rarely take monetary policy action immediately ahead of an important election or other significant international milestone such as a summit meeting. The political and emotional nature of the ECB QE debate provides one more reason why the ECB on 22 January may prefer to limit itself to small-scale technical measures and once more delay a big decision.

Any QE involving purchases of Greek bonds that are likely to fall dramatically post-poll would expose the ECB to unacceptable losses. Yet, equally, the ECB would find it very difficult to launch QE involving purchases of all EMU members' government bonds apart from Greece’s. This would stigmatise Athens, and precipitate the very Greek bond sell-off that the ECB wishes to avoid.

Alexis Tsipras, leader of the left-wing Syriza party which opinion polls put in the lead for 25 January, confirmed this at a weekend party rally, in which he condemned any ECB move to exclude Greece from a QE package. In an astoundingly open invitation for the ECB to make large losses, Tsipras challenged Mario Draghi, the ECB president, to go ahead with full-scale QE including Greece – and said that after the election Greece would write off much of its foreign debt, including presumably the ECB’s own holdings.

Other countries with lower credit ratings, including those still recovering from the EMU debt crisis such as Portugal, Ireland and Spain, would probably view as discriminatory any ECB action confined only to the better-rated bonds. They would see this as widening interest rate spreads between the EMU periphery and core members, undoing some of the remedial action the former countries have taken in recent years.

Peter Praet, ECB board member responsible for economics, confirmed in a New Year interview with German daily Börsen-Zeitung (stressing he was speaking ‘theoretically’) that the ECB could decide to buy only triple A-rated bonds, or allow each central bank to carry out its purchases at its own risk. Both ideas have been floated as possible conditions by Jens Weidmann, the Bundesbank president. However, such structures would undermine the guiding principle of solidarity among member states that has been a bedrock of EMU’s working practices since it started in 1999.

As Praet has admitted, if the ECB decided to limit purchases to triple A-rated securities, that would substantially increase the amounts required to be purchased, which would run into further German objections. It would open up a debate on whether France should be seen as a triple A-rated borrower along with Germany and the Netherlands. And it would place the ECB in the supremely illogical, if not untenable, position of lowering interest rates in core countries where economic prospects are already quite strong, and raising them in the struggling periphery – a technical, legal and political minefield from which no country would emerge unscathed.

If the ECB went further to meet German conditions and allowed countries to invest in government securities at their own risk, and on their own conditions, then that could result in the Bundesbank participating in the exercise in only token amounts. This would add up to a striking symbolic defeat for Draghi. Paradoxically, it could end up increasing rather than diminishing demand for top-rated German government bonds, as large foreign holders of, say, French euro issues could take advantage of Banque de France purchases of these bonds and switch to less expensive German issues. There are good reasons for thinking that Draghi would rather avoid such an outcome.

The position of ECB governing council members taking a ‘wait and see’ line over QE will have been strengthened by the view broadcast by leading ECB officials over the New Year playing down any imminent danger of euro area deflation. Draghi told the German daily Handelsblatt. ‘The risk [of deflation] cannot be ruled out completely, but it is limited,’ although he said inflation expectations had been falling since June.

Whatever happens, as the campaign for the Greek election picks up steam, tussling over blame and responsibility for the euro malaise will rise. In this highly-charged atmosphere, the ECB will wish to remain as neutral as possible.